It’s tax refund season again, and if you are considering filing bankruptcy there are some really important things you need to know about that long- awaited refund.

#1: Never Use Tax Refunds to Repay Family Loans:  

Do not use that tax refund to repay family loans.  You must report every payment made to a family member within one year of filing bankruptcy. Family members are considered “insiders” under the bankruptcy law, and such payments may be recovered by the bankruptcy Trustee.  In other words, if you pay back a loan to a family member within a year of bankruptcy, the court trustee can sue that person to recover the money.

It is normal to use a tax refund to pay back family loans, and there is nothing illegal about such payments.  However, when you file bankruptcy the law tries to make sure that some creditors, like family members or business partners, are not unjustly favored just before the case is filed while other creditors go unpaid.  So, bankruptcy law empowers the Trustee to void such “preference” payments.

The solution to this problem?  Pay relatives after the bankruptcy is filed, never before.

#2: Only So Much of the Tax Refund is Protected:

There are two Nebraska exemption laws that protect tax refunds:

If you are anticipating a tax refund of more than these protected amounts, then it may be wise to not file the bankruptcy until after the tax refund is received and spent. It is common for our firm to recommend that clients wait until after the tax return is received before they actually file the bankruptcy case.

#3:  Tax Refunds are Pro-rated During the Year

Those folks who file bankruptcy in the months of October, November and December may find that the Chapter 7 trustee will claim a pro-rata share of their upcoming tax refund.  For example, if you anticipate receiving a $6,000 tax refund and you file a bankruptcy case on October 31, the Chapter 7 trustee may claim 83% of your tax refund since that much of the calendar year has expired.

#4:  Be Prepared to Explain How You Spent the Tax Refund

If you receive a large tax refund shortly before filing bankruptcy, be prepared to explain how you spent the refund. How did you spend that $6,000 refund you received a month prior to filing bankruptcy?  The Chapter 7 Trustee will likely ask that question at the court meeting that occurs a few weeks after the bankruptcy is filed.  Write down a list of how you spent the money.  In fact, a good bankruptcy attorney should actually provide this information in the bankruptcy schedules.  You would be amazed at how many debtors get nervous at the hearing and confess that they repaid family loans or transferred money to their fiancé to “hold” until the bankruptcy is over.  This should never happen–never!  Yet, cheap bankruptcy attorneys routinely and lazily fail to anticipate the obvious questions a Trustee may ask and their clients wind up losing their refund for no good reason.

#5:  The IRS May Seize Your Tax Refund

Do you owe the IRS money?  If so, they have the right to take your tax refund even if you file bankruptcy.  However, special rules apply.  Generally, individual income taxes are discharged in bankruptcy if the return was filed and if it became due more than three (3) years before the bankruptcy was filed.  For example, if you owe $10,000 for income taxes owed in the year 2012 and the return was filed by the normal due date of April 15, 2013, that tax will be discharged in bankruptcy filed in 2017.  So, if you are owed a $6,000 tax refund for tax year 2016 and you file the bankruptcy on December 31, 2016, you will receive the tax refund.  However, if you file the bankruptcy on January 1, 2017, you will lose the tax refund because the IRS has the right to offset.  In both cases the underlying $10,000 tax debt owed for 2012 is discharged, but the offset right does not materialize until you have a right to the refund.  The right to the 2016 refund does not exist until January 1, 2017.  One day makes the difference.  Your bankruptcy attorney should understand this key timing issue, but many do not.  Choose your bankruptcy attorney carefully.

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